How to calculate: Municipal bonds vs. Federal bonds

Municipal Bonds (or Muni Bonds as they are often called) are bonds issued by a city or county to finance the local budget, usually denoted for specific projects like new schools. Muni bonds are extremely low risk for the investor, since cities can always raise taxes to raise money. (However, there was a famous defaulting of muni bonds in California in 1994.)

The great thing about municipal bonds is that if you purchase them from the state in which you live and pay taxes, they are state tax free most of the time . (Be sure to check the individual bond you are buying.)

Like other bonds, your profit on a bond is determined by two pieces: the stated coupon rate (the interest rate they pay you), and the price you paid for the bond relative to the par value (usually $100). This is usually calculated for you and stated as the Yield to Maturity, or YTM.

Should you buy Muni bonds or Federal bonds? Here's how to figure it out:

First you need to know your federal and state tax brackets. Pull your tax return from last year (you should keep those somewhere safe and organized) and find your taxable income. Then consult the "tax schedule" for the Federal and State taxes. (I've linked the federal schedule. You'll have to google a term like "North Carolina tax schedule 2007" to find for your specific state.)

For example, if you live in NC and had $50,000 of taxable income in 2006, that puts you in the 25% federal bracket. That also puts you in the 7% NC state tax bracket. That's a total tax bracket of 32%. To compare the return on a federal govt. bond to the return on a muni bond, simply plug in the following formula.

Muni rate / (1- tax bracket)

So if you have a choice between a muni bond paying 3.5% and a federal govt. bond paying 5.4%, which should you choose?

The Muni bond is equal to a taxable bond paying .035/(1-.32) = .035/.68 = 5.14%

Therefore the federal bond is better for you.

However, if you were in the 40% total tax bracket:

The Muni bond is equal to a taxable bond paying .035/(1-.40) = .035/.6 = 5.83%

Since 5.83% is better than the 5.4% you could get from a federal bond, the muni would be better for your situation.

NOTE: This assumes you are thinking of holding federal or muni bonds in a taxable account. If you are considering purchasing bonds for a non-taxable account such as a Roth IRA, you should not consider munis, because interest payments on all types of bonds are tax free.